Aggressive Financial Reporting and Corporate Fraud

Abstract

This study documents new evidence on the relationship between firms financial reporting behavior and engagement in corporate fraud. Using a matched sample of 184 companies over an eight-year period from 2003 to 2010, we empirically examine whether firms that practice aggressive financial reporting are more likely to be involved in corporate fraud. We determine aggressive financial reporting by (1) conducting a time-series test of timely loss recognition and (2) using asymmetric timeliness of earnings models. Our results show that firms with fraudulent financial statements employ aggressive financial reporting during the two years prior to the occurrence of fraud. Specifically, we found that firms engaged in fraud have significantly less timely loss recognition and lower asymmetric timeliness of earnings compared to firms not engaged in fraud. The result is robust even after including various controls. We conclude that aggressive reporting provides an early sign of the potential for corporate fraud, and thus contributes towards efforts to deter fraud.